The two biggest technology stocks in China are Alibaba (BABA, Financial)(HKSE:09988, Financial) and Tencent (TCEHY, Financial)(HKSE:00700, Financial). These companies are very different in their operations, with Alibaba being focused on e-commerce and cloud computing and Tencent focusing on social media and video games. As they are held by many institutional funds, they both offer relatively safe ways for U.S. investors to diversify into China.
So, why am I talking about Alibaba and Tencent instead of, say, Amazon (AMZN, Financial) and Meta (META, Financial)? Because China is the country that has the world’s largest population, and it also has a growing middle class (as compared to the shrinking middle class in the U.S.) and a forecasted GDP growth of ~5% in 2023 (wheras U.S. GDP growth estimates range around the flat to negative space for 2023). Thus, let's take a look at Alibaba and Tencent to see if one of these companies has better prospects than the other.
1. Alibaba
Alibaba (BABA, Financial)(HKSE:09988, Financial) is the largest e-commerce company in China. The business was founded by Jack Ma, whose criticism of the Chinese financial system combined with his controlling stake in Ant Group is rumored to have been why the planned IPO of Ant Group was halted. The good news is Ant Group announced a restructuring which reduced the official ownership control of Ma in early 2023. This was a positive sign as it could pave the way for an IPO and capital raise. However, Alibaba doesn't plan to stop there and has announced plans to split the company into six businesses.
I believe this is a good development for shareholders as it means Alibaba will likely get itself out of the regulatory hot seat. In addition, separate segments should result in faster decision-making and greater accountability for each individual segment. Spliting up is also expected to unlock greater shareholder value as investors tend to value simpler business models more richly.
Financial challenges
Alibaba reported disappointing financial results for the third quarter of its fiscal year 2023. Its revenue was $35.9 billion, which rose by just 1% year over year, driven by weakness in China Commerce, which had a 1% decline in revenue to $24.5 billion. The good news is, China has finally ended its Covid lockdown policies, which should drive business. The International Monetary Fund forecasts China’s GDP growth to be 4.7% in 2023, up from 3.8% in 2022, on the reopening.
The logistics segment Cainiao generated strong revenue growth of 27% in the quarter. The cloud segment grew its revenue grew by just 3% year over year. However, given a forecast by McKinsey & Co predicts the cloud industry in China will close to triple its value to ~$90 billion by 2025, I expect Alibaba to benefit as the market leader.
Valuation
Alibaba trades at a price-sales ratio of 2.16, which is 67% cheaper than its five-year average. The company also trades at an adjusted (non-GAAP) price-earnings ratio of 13, which is 41% cheaper than its five-year average.
The GF Value chart indicates a fair value of $218 per share and thus the stock is “significantly undervalued” at the time of writing.
2. Tencent
Tencent (TCEHY, Financial)(HKSE:00700, Financial) is the largest social media and gaming company in China. Its flagship social media application WeChat has a staggering 1.3 billion monthly active users and can be used for pretty much everything as a “Super App." Its features include the standard talk/text/voice/note features like you see on WhatsApp. However, it also includes “moments,” which is similar to the Facebook News feed. In addition, WeChat is not just a social media app but a platform that developers can use to build integrations on top called “mini programs." For example, WeChat integrates directly with DiDi (DIDIY, Financial) and thus can be used to directly call a Taxi.
WeChat also has WeChat Pay, which is the most popular payments app in China and has ~39.5% market share. This product competes against Alibaba's Alipay, which has ~35% stake in the market, according to a study by eMarketer. It should be noted that Alipay was originally part of Alibaba, but is now part of the Ant Group of which Alibaba owns a 33% stake.
Mixed financials
Tencent reported mixed financial results for its fourth quarter of 2022. Its revenue was $20.8 billion, which increased by just 0.5% year over year in Renminbi but declined by 7.37% on a U.S. dollar basis.
A positive is foreign exchange rates tend to be cyclical by nature and the U.S. dollar has weakened by ~7% against the Renminbi between October 2022 and April 2023. In addition, China has recently announced a deal with Brazil to use the Renminbi for trade between the two countries as opposed to the U.S. dollar, and thus I expect strengthening in the Chinese currency moving forward. However, I think it's possible Brazil may walk back on the deal as it could upset relations with the U.S., even though it saves Brazil a lot of money due to the strength of the greenback combined with the high volume of trade between Brazil and China.
By segment, Tencent's Value Added Services (VAS) contributed to the majority (49%) of revenue, $10.3 billion, down ~2% year over year. This was mainly impacted by a 2% drop in social media revenue due to lower consumer demand for its in-app "stickers" which are often used as an extra bonus purchase.
In addition, Tencent is facing fierce competition from Bytedance, which reported a rapid 30% growth in sales to $80 billion, matching Tencent. This means Tencent is now being challenged on social media for the first time in decades. Bytedance owns TikTok, which is growing rapidly in the West, and Douyin, which is growing rapidly in China.
Tencent’s gaming segment revenue declined by 6% year over year to ~$4 billion. This was driven by lower domestic purchases after the government announced regulation on gaming times for minors. A positive is Tencent’s international gaming revenue increased by 5% year over year to $2 billion. As the gaming industry rebounds in the West, I expect Tencent to benefit.
Overall, Tencent has reported strong growth in its profitability, with operating income increasing by 19% year over year to $5.7 billion. Tencent also has a strong operating margin of 21%, which is substantially better than Alibaba's at just 13%.
Moving on to the balance sheet, Tencent has a strong balance sheet with $42.16 billion in cash and short-term investments. This is strong overall, but Alibaba has even more cash at ~$75.2 billion. However, what these metrics don’t take into account is Tencent's vast investment portfolio spread out across many of the greatest companies in the world. For example, Tencent owns a ~5% stake in Tesla (TSLA, Financial) as well as a stake in Spotify (SPOT, Financial), NIO (NIO, Financial) and many more. I estimate the total value of these investments at ~$98.5 billion based on the lastest financials.
Valuation
Tencent trades at a price-sales ratio of 5.82, which is ~88% cheaper than its five-year average.
Final thoughts
Tencent and Alibaba are two fantastic technology giants which are trading much cheaper than historical levels. I believe Alibaba’s proposed split is a positive sign and should help to create greater shareholder value. Tencent is facing challenges in its domestic social market with Douyin and TikTok experiencing strong growth. However, I believe Tencent can rebound along with the international gaming market.
Personally, I think Alibaba is a better value as it has plans to split into six business segments, which could be a catalyst to unlock better valuations for each individual segment. However, Tencent has higher margins, and its investment portfolio helps to diversify the company, so I think Tencent is the better quality company.
